Question

Use you knowledge of indifference curves, substitution effects, equivalent variation, and compensating variation to explain why subsidizing the use of water is inefficient. Assume subsidization takes the form of reducing the price of water paid by a consumer from pw to (1–s)pw where s is the subsidy rate.

please add graphs as well.

thank you

Answer 1

Water is one of those critically necessary goods which is an impediment to the survival of the living organism. Every living organism requires adequate amount of water consumption for survival. The consumption of water is highly essential, which makes water a critically necessary and highly demanded good. However, we must also note here that we only need water up to a certain requirement. For example, let us assume that we need 10 glasses of water in a day. If we have 8 or 9 glasses of water available and the rest of 1-2 glasses of water are missing, we might still be able to survive, although we may have to sacrifice some value of the water consumption. But if we have less than 6-7 glasses of water, it may then become difficult for us to survive. Similarly, if we have more glasses of water available in front of us, the extra glasses of water are actually of no economic value to us or for our satisfaction. Even if we consume the extra glass(s) , even then, the economic benefit derived out of it or its value will be nonexistent.
                  If we go by the economic theories or principles like that of indifference curve or substitution effect, equivalent variation and compensation variation, the crux of all these principles or theories will be that water is a good for which the indifference curve will be extremely rigid, and therefore subsidizing the use of water which thereby is expected to reduce the price of water being paid by a consumer will be a totally inefficient and result less action as the consumer will keep on consuming the required amount of water. Similarly, as per the substitution affect too, water is not substitutable by any other good, therefore, its substitution affect is zero. Similarly, equivalent variation also states that water cannot be equated with the liquified consumption of any other good, therefore making its economic variability zero. Also, the same goes with compensation variation, which also states that people will be ready to pay any amount of money to compensate the loss of their utility of consumption of water. Therefore, if a Government subsidizes the use of water, it will create a sense of anti-Government among the consumers. Moreover, it will never reduce the required consumption of water.